What caused the Great Depression? The crash and after

The Great Depression was caused by a chain of failures, not a single event. A downturn that began in the summer of 1929 was deepened by the stock market crash that October, then turned into a collapse by waves of bank failures, a money supply that shrank by nearly a third, a gold standard that spread the damage across countries, and tariffs that choked trade. In the United States it lasted, with one relapse, until the Second World War.

In short

• The crash of 1929 hurt, but on its own it would likely have caused a severe recession, not a decade of depression.
• The worst damage came from banking panics in 1930–1933 and a Federal Reserve that let the money supply fall by nearly 30%.
• Countries recovered roughly in the order they left the gold standard, which is one reason economists now see it as central.

Was it the 1929 stock market crash?

The crash was the start, not the whole story. The Dow Jones Industrial Average peaked at 381.17 on 3 September 1929. On 28 October, Black Monday, it fell nearly 13%, and the next day, Black Tuesday, nearly 12% more. By 8 July 1932 it had fallen to 41.22, 89% below its peak, according to the Federal Reserve's history of the crash.

But the economy had already begun to shrink in August 1929, before the crash, after the Federal Reserve raised interest rates in 1928 and 1929 to cool stock speculation. And the crash's direct effects faded within months: by the autumn of 1930, many observers thought recovery was near. What turned a bad recession into a depression happened next, in the banks. The dot-com crash of 2000 also wiped out trillions of dollars of stock value and was followed by only a mild recession, which shows that a crash alone doesn't make a depression.

How did bank failures make it worse?

In late 1930, depositors began to fear for their banks and rushed to withdraw cash. Banks keep only a fraction of deposits on hand, so a run could break even a sound bank. Hundreds failed within weeks in a panic that began in November 1930, and the Bank of United States, one of New York City's largest, closed on 11 December. More waves followed in 1931 and early 1933. In October 1931 alone, 522 commercial banks closed. Over the decade, roughly half of all American commercial banks failed or merged, as Ben Bernanke later noted.

Each failure destroyed deposits, which are most of the money people use. Surviving banks hoarded cash and stopped lending, and households kept money under the mattress. From the autumn of 1930 to the winter of 1933, the money supply fell by nearly 30%, and prices fell by about as much. Falling prices sound good for buyers, but they made every debt harder to repay, which pushed more borrowers and banks into default.

The Federal Reserve, created in 1913 partly to stop exactly this kind of panic, did little. It failed to lend freely to troubled banks and let the money supply shrink. Milton Friedman and Anna Schwartz made this case in their 1963 A Monetary History of the United States, and it became the mainstream view. In 2002, Bernanke, then a Fed governor, ended a speech honoring Friedman with: "Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again."

What did the gold standard have to do with it?

Under the gold standard, a country promised to swap its currency for a fixed amount of gold: $20.67 an ounce in the United States. That tied countries' money and interest rates together. When gold flowed out, a central bank had to raise rates to defend its promise, even in a slump.

That is what happened in September 1931. Britain left the gold standard, and investors began swapping dollars for gold. The Fed raised interest rates sharply to defend the dollar, in the middle of a banking panic, which made the panic worse. Across the world, countries that held on to gold kept tightening, and those that left could ease. Barry Eichengreen and Jeffrey Sachs found that recovery in most leading industrial countries began when they left gold and let their money expand. Britain, out in 1931, began to recover earlier than France, which held on until 1936.

The United States suspended the gold standard on 20 April 1933, a month after a national banking holiday closed every bank in the country. The Gold Reserve Act of January 1934 later fixed gold at $35 an ounce, a devaluation of the dollar. March 1933 marked the bottom.

Did tariffs cause the Depression?

Tariffs made it worse but are not usually seen as the main cause. The Tariff Act of 1930, known as Smoot-Hawley, raised American duties on thousands of imported goods, and other countries retaliated with barriers of their own. World trade fell by about 66% between 1929 and 1934, according to the U.S. State Department's Office of the Historian, and American exports to Europe fell from $2.3 billion in 1929 to $0.8 billion in 1932. How much of that fall came from tariffs, and how much from collapsing incomes and prices, is still debated by economic historians.

The Great Depression, year by year

When	What happened
1928–1929	The Fed raises interest rates to curb stock speculation
August 1929	The economy starts to shrink
3 September 1929	The Dow peaks at 381.17
28–29 October 1929	The crash: the Dow loses nearly a quarter of its value in two days
June 1930	Smoot-Hawley tariff becomes law
November–December 1930	First banking panic; Bank of United States fails
September 1931	Britain leaves gold; the Fed raises rates to defend the dollar
8 July 1932	The Dow bottoms at 41.22, down 89%
March 1933	National banking holiday; the economy hits bottom
April 1933	The United States suspends the gold standard
1933–1934	Federal deposit insurance created; gold fixed at $35 an ounce
1937–1938	Relapse: real GDP falls 10% and unemployment returns to 20% after the Fed doubles reserve requirements and taxes rise
1941	The United States enters the Second World War, and wartime spending ends mass unemployment

By the bottom in 1933, American output had fallen by more than a quarter from its 1929 peak, and about a quarter of the labor force was out of work: Stanley Lebergott's widely used estimate puts 1933 unemployment at 24.9%.

Which explanation is right?

Still argued

Economists agree on the events but weigh the causes differently. The monetarist view, from Friedman and Schwartz, blames the Fed for letting the money supply collapse. Keynesian economists, such as Peter Temin, put more weight on a collapse in spending, as households and firms cut back and demand fed on itself; in that view monetary policy alone could not have fixed it. The gold standard view, associated with Eichengreen, explains why the slump was global and why recovery came in the order countries left gold. Others argue that parts of the New Deal, such as rules that let industries raise prices and wages, slowed the recovery after 1933. These views overlap more than they conflict, and most economists today combine the first three.

What did policy learn from it?

The Depression reshaped economic policy. Deposit insurance, run by the Federal Deposit Insurance Corporation from 1934, ended most bank runs by depositors. Central banks learned to act as lenders of last resort in a panic and to prevent the money supply from collapsing. Governments learned that sticking to a fixed exchange rate in a slump can be ruinous. And macroeconomics itself, the study of the economy as a whole that sits at the center of economics today, grew out of the effort to explain it.

Those lessons were tested in 2008, when Bernanke was chairing the Federal Reserve. The Fed lent heavily and pumped money into the system, partly so as not to repeat the 1930s. Whether that response worked, and at what cost, is the story of the 2008 financial crisis.

Check yourself

• Without looking back: why wasn't the 1929 crash, on its own, enough to cause a decade-long depression?
• How did bank failures shrink the money supply, and why did falling prices make things worse?
• Why did countries that left the gold standard tend to recover sooner?

Sources

• The Great Depression — Gary Richardson, Federal Reserve History, 2013
• Stock Market Crash of 1929 — Federal Reserve History
• Banking Panics of 1930–31 — Federal Reserve History
• Remarks by Governor Ben S. Bernanke on Milton Friedman's ninetieth birthday — Board of Governors of the Federal Reserve System, 2002
• Roosevelt's Gold Program — Federal Reserve History
• Protectionism in the Interwar Period — Office of the Historian, U.S. Department of State